Hobby loss or business loss? There's a big difference for working RVers when it comes to what you can legally deduct. An income tax expert offers help in making sure your business is seen as a business in the eyes of the IRS.
Can You Deduct Losses from Your Business?
by Martin M. Shenkman, CPA, MBA, JD
While you hope to make a profit from the business you conduct while you're RV'ing, the reality is that the economic downturn, perhaps an off year, some unanticipated expenses, or just the start-up of a new business, can make that pretty difficult. If you can use the losses incurred on one business to offset other income (e.g., earnings on retirement savings, or wages earned on another job) at least the tax write-offs will soften the blow of your business losses. But, alas, as with so many tax bennies, the reality is tougher and more complex than what almost anyone would imagine. There are a number of tough rules that could limit, or even eliminate, the losses you can deduct. Let's take a look at one of them in this article, the so-called "hobby loss" limitations.
Technical references and items are in Italics so you can skip them if you wish, or Google them if you want to find more details.
Hobby Loss Tax Trap Dangerous To RV'ers
In simple terms, if you realize losses on a "business" too many years in a row, the IRS will argue that what you say was a business was merely a hobby, so that the loss is a personal one that you cannot deduct. While you might use your RV because it provides a more economical way to leave, the reality is that in many cases RV living costs can be more than renting an apartment or owning a small condo. RV'ing in most cases is done because of the personal satisfaction with the lifestyle it affords. If some of the costs incurred in creating your business loss relate to your RV or RV lifestyle, the IRS may argue that there was a personal component and therefore the losses are not deductible. The personal pleasure from the RV lifestyle will be used to argue that the "business" generating a tax loss (or so you thought!) did not have a true profit motive.
Tax Forms Where You Report Hobby Losses
If you run your own business (even if it is organized as a one-member limited liability company) it is generally reported on your personal income tax return, Form 1040, Schedule C. But if the IRS can successfully challenge the activity as being only a hobby the deductions you otherwise would have been able to claim on Schedule C can only be deducted on your Form 1040, Schedule A, i.e., as an itemized deduction. This can be uglier than it sounds in that there is a number of limitations and restrictions on what itemized deductions you can benefit from. Treas. Reg. Sec. 1.183-1(b). One of the restrictions is that these hobby loss deductions are treated as miscellaneous itemized deductions, which are reduced by 2% of your adjusted gross income (AGI). These amounts cannot be deducted for alternative minimum tax (AMT) purposes. How bad is this you ask? You could end up having to report taxable income to the IRS even though you had deductions that were more than your revenue!
Planning to Avoid the Hobby Loss Tax Restrictions
Since having the IRS classify what you thought was a business as a mere hobby has such a horrific tax result, you obviously want to do whatever you can to avoid this situation. There are two general approaches to avoid the problem.
#1: The first approach is to prove to the IRS that you have a real business and really intended to make a profit. This is referred to as a "facts and circumstances" approach. Whenever you see a "facts and circumstances" test in the tax law, it means you have to be rather diligent, and if you want to figure out the ground rules required to convince the IRS you'll have to do a fair amount of reading and analyzing to determine what facts are good and which aren't. Then you'll have to plan your actions to maximize the good facts and minimize the bad facts. The real problem with a "facts and circumstances" approach is that you really cannot ever be certain as to how the IRS will view the matter until you discuss it on an audit. What are some of the facts to show a profit motive? Treas. Reg. Sec. 1.183-2.
• Conduct your business activity in a "businesslike" manner.
• Maintaining complete and accurate books and records. If you don't have a computer software package for your business, like Quickbooks, buy one and start using it.
• Develop and maintain a business or marketing plan. Your small business doesn't need a plan? Well for the modest cost of some of the computer programs or websites that help you develop a business plan, perhaps it is a worthwhile investment even if the information it gives you is only fair or even marginal.
• Prepare income or expense projections. If you have a computer program to keep your business checkbook and other accounts, it may be able to generate forecasts.
• Maintain a separate checking account for the business (don't commingle funds with personal money). Never mix personal and business funds.
• Alter your operating methods to improve profitability.
• Devote a substantial amount of time and effort to the business. Keep a log to prove what you do. If the business or activity has significant personal or recreational aspects, the fact that you devote substantial time and effort to it may not be a strong indication of profit motive. Isn't one of the reasons you bought an RV in the first place was to enjoy it? So, the mere fact that your business is in an RV probably starts you off on a bad foot with the IRS if you get audited. There is even a website rvfamilyfun.com. Google "RV" and "fun" and see how many entries come up! Be conscious if everything you post on your Blog is about how much fun you're having. The IRS auditors know how to Google search you.
• Your prior success at making a business profitable.
• Your need for income from the business. If you're a trust fund baby living off monthly distribution checks you're less likely to convince the IRS that your money losing business is the real McCoy.
• Advertising in trade magazines. Save the advertisements to prove the profit motive if you're later audited.
• Attending seminars geared towards your business or towards business in general.
• Consulting with an accountant with respect to the business.
The mere fact that you have your business set up (structured) as a corporation or limited liability company (LLC) won't alone assure that the IRS won't try to treat it as a hobby and not a real business.
#2: The second approach is to try to take advantage of a special rule that lets you avoid the lousy hobby loss tax results if you meet certain tests. Here they are: The activity which you want to treat as a real business for tax purposes and not as a hobby must generate a profit in at least three of five years ending with the tax year involved. Or for activities involving horse racing, horse breeding, or horse showing, it must generate a profit in at least two out of seven years ending with the tax year involved. IRC Sec. 183(d).
You may be able to plan when you pay for certain expenses so that you can shift expenses into particular years so that other years will show a profit.
You may think what you have is a business, but unless you operate it in a real business like fashion, the IRS may take a different view of what you're doing as being merely a hobby. The tax results if you lose that argument can be pretty costly. Do your homework and carefully plan to demonstrate that your business is real.
For more information see the IRS website information at http://www.irs.gov/irs/article/0,,id=186056,00.html or Google the technical tax references in Italics above.
Martin M. Shenkman, CPA, Esq. sponsors a free legal website LawEasy.com.
Martin is an RVer with a special cause. He is an avid fundraiser for the National Multiple Sclerosis Society and The Michael J. Fox Foundation For Parkinson's Research. Besides RV business tax and legal information, he will share some of his RVing and fundraising experiences with us.
Judy Justice has an MBA in Management and an MBA in Financial Management. She teaches online and operates a business with her husband while RV'ing.
Caution: This article and other columns can never substitute for professional legal, tax, and accounting guidance. These columns can provide only broad general advice, which may not apply to your situation. The rules differ substantially from state to state. Tax, business, and other laws change rapidly over time so there can be no assurance that the information in this column is current. The best approach is to review the ideas in this article with your own CPA and attorney. The application of general tax and legal principles to some of the unique facts presented by RV working is particularly complex and there is little specific law providing guidance to rely upon.